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CHAPTER 11Depreciation, Impairments, and Depletion

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Topics QuestionsBrief

Exercises Exercises Problems Conceptsfor Analysis

1. Depreciation methods;meaning of depreciation;choice of depreciationmethods.

1, 2, 3, 4, 5,6, 14, 20,21, 22, 23

1, 2, 3, 4,5, 8, 14, 15

1, 2, 3 1, 2, 3, 4, 5

2. Computation of depre-ciation.

7, 8, 9,10, 14

1, 2, 3, 4 1, 2, 3, 4,5, 6, 7, 10,14, 15

1, 2, 3, 4,11, 12

1, 2, 3

3. Depreciation base. 6 5 8, 17 1, 2, 3 3

4. Errors; changes inestimate.

13 7 11, 12,13, 14

3, 4 3

5. Depreciation of partialperiods.

15 3, 4 3, 4, 5,7, 15

1, 2, 3, 8,10, 11

6. Composite method. 11, 12 6 9 2

7. Impairment of value. 16, 17,18, 19

8 16, 17, 18 9

8. Depletion. 22, 23, 24,25, 26, 27

9 19, 20, 21,22, 23

5, 6, 7

9. Ratio analysis. 28 10 24

*10. Tax depreciation(MACRS).

29 11 25, 26 12

*This material is covered in an Appendix to the chapter.

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ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives BriefExercises Exercises Problems

1. Explain the concept of depreciation.

2. Identify the factors involved in the depreciationprocess.

2, 3, 4, 5, 7 1, 2, 3, 4, 5, 6,7, 8, 9, 10, 11,12, 13, 14, 15

1, 2, 3,4, 8, 10,11, 12

3. Compare activity, straight-line and decreasing-charge methods of depreciation.

2, 3, 4, 5 1, 2, 3, 4, 5, 6,7, 8, 9, 10, 11,12, 13, 14, 15

1, 2, 3, 4,5, 8, 10,11, 12

4. Explain special depreciation methods. 1, 6

5. Explain the accounting issues related to assetimpairment.

8 16, 17, 18 9

6. Explain the accounting procedures fordepletion of natural resources.

9 19, 20, 21,22, 23

5, 6, 7

7. Explain how to report and analyze property,plant, equipment, and natural resources.

10 24

*8. Describe income tax methods of depreciation. 11 25, 26 12

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ASSIGNMENT CHARACTERISTICS TABLE

Item DescriptionLevel ofDifficulty

Time(minutes)

E11-1 Depreciation computations—SL, SYD, DDB. Simple 15–20 E11-2 Depreciation—conceptual understanding. Moderate 20–25 E11-3 Depreciation computations—SYD, DDB—partial periods. Simple 15–20 E11-4 Depreciation computations—five methods. Simple 15–25 E11-5 Depreciation computations—four methods. Simple 20–25 E11-6 Depreciation computations—five methods, partial

periods.Moderate 25–35

E11-7 Different methods of depreciation. Simple 20–30 E11-8 Depreciation computation—replacement, nonmonetary

exchange.Moderate 20–25

E11-9 Composite depreciation. Simple 15–20 E11-10 Depreciation computations, SYD. Simple 10–15 E11-11 Depreciation—change in estimate. Simple 10–15 E11-12 Depreciation computation—addition, change in estimate. Simple 20–25 E11-13 Depreciation—replacement, change in estimate. Simple 15–20 E11-14 Error analysis and depreciation, SL and SYD. Moderate 20–25 E11-15 Depreciation for fractional periods. Moderate 25–35 E11-16 Impairment. Simple 10–15 E11-17 Impairment. Simple 15–20 E11-18 Impairment. Simple 15–20 E11-19 Depletion computations—timber. Simple 15–20 E11-20 Depletion computations—oil. Simple 10–15 E11-21 Depletion computations—timber. Simple 15–20 E11-22 Depletion computations—mining. Simple 15–20 E11-23 Depletion computations—minerals. Simple 15–20 E11-24 Ratio analysis. Moderate 15–20*E11-25 Book versus tax (MACRS) depreciation. Moderate 20–25*E11-26 Book versus tax (MACRS) depreciation. Moderate 15–20

P11-1 Depreciation for partial period—SL, SYD, and DDB. Simple 25–30 P11-2 Depreciation for partial periods—SL, Act., SYD, and

DDB.Simple 25–35

P11-3 Depreciation—SYD, Act., SL, and DDB. Moderate 40–50 P11-4 Depreciation and error analysis. Complex 45–60 P11-5 Depletion and depreciation—mining. Moderate 25–30 P11-6 Depletion, timber, and extraordinary loss. Moderate 25–30 P11-7 Natural resources—timber. Moderate 25–35 P11-8 Comprehensive fixed asset problem. Moderate 25–35 P11-9 Impairment. Moderate 15–25 P11-10 Comprehensive depreciation computations. Complex 45–60

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ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Item DescriptionLevel ofDifficulty

Time(minutes)

P11-11 Depreciation for partial periods—SL, Act., SYD, andDDB.

Moderate 30–35

*P11-12 Depreciation—SL, DDB, SYD, Act., and MACRS. Moderate 25–35

CA11-1 Depreciation basic concepts. Moderate 25–35 CA11-2 Unit, group, and composite depreciation. Simple 20–25 CA11-3 Depreciation—strike, units-of-production, obsolescence. Moderate 25–35 CA11-4 Depreciation concepts. Moderate 25–35 CA11-5 Depreciation choice—ethics Moderate 20–25

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ANSWERS TO QUESTIONS

1. The differences among the terms depreciation, depletion, and amortization are that they imply acost allocation of different types of assets. Depreciation is employed to indicate that tangible plantassets have decreased in carrying value. Where natural resources (wasting assets) such astimber, oil, coal, and lead are involved, the term depletion is used. The expiration of intangibleassets such as patents or copyrights is referred to as amortization.

2. The factors relevant in determining the annual depreciation for a depreciable asset are the initialrecorded amount (cost), estimated salvage value, estimated useful life, and depreciation method.

Assets are typically recorded at their acquisition cost, which is in most cases objectivelydeterminable. But cost assignments in other cases—“basket purchases” and the selection of animplicit interest rate in asset acquisition under deferred-payment plans—may be quite subjective,involving considerable judgment.

The salvage value is an estimate of an amount potentially realizable when the asset is retired fromservice. The estimate is based on judgment and is affected by the length of the useful life of theasset.

The useful life is also based on judgment. It involves selecting the “unit” of measure of service lifeand estimating the number of such units embodied in the asset. Such units may be measured interms of time periods or in terms of activity (for example, years or machine hours). When selectingthe life, one should select the lower (shorter) of the physical life or the economic life. Physical lifeinvolves wear and tear and casualties; economic life involves such things as technologicalobsolescence and inadequacy.

Selecting the depreciation method is generally a judgment decision, but a method may be inherentin the definition adopted for the units of service life, as discussed earlier. For example, if such unitsare machine hours, the method is a function of the number of machine hours used during eachperiod. A method should be selected that will best measure the portion of services expiring eachperiod. Once a method is selected, it may be objectively applied by using a predetermined,objectively derived formula.

3. Accounting depreciation is defined as an accounting process of allocating the costs of tangibleassets to expense in a systematic and rational manner to the periods expected to benefit from theuse of the asset. Thus, depreciation is not a matter of valuation but a means of cost allocation.

4. The carrying value of a fixed asset is its cost less accumulated depreciation. If the company estimatesthat the asset will have an unrealistically long life, periodic depreciation charges, and henceaccumulated depreciation, will be lower. As a result the carrying value of the asset will be higher.

5. A change in the amount of annual depreciation recorded does not change the facts about thedecline in economic usefulness. It merely changes reported figures. Depreciation in accountingconsists of allocating the cost of an asset over its useful life in a systematic and rational manner.Abnormal obsolescence, as suggested by the plant manager, would justify more rapid deprecia-tion, but increasing the depreciation charge would not necessarily result in funds for replacement.It would not increase revenue but simply make reported income lower than it would have been,thus preventing overstatement of net income.

Recording depreciation on the books does not set aside any assets for eventual replacement ofthe depreciated assets. Fund segregation can be accomplished but it requires additionalmanagerial action. Unless an increase in depreciation is accompanied by an increase in salesprice of the product, or unless it affects management’s decision on dividend policy, it does not

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Questions Chapter 11 (Continued)

affect funds. Ordinarily higher depreciation will not lead to higher sales prices and thus to morerapid “recovery” of the cost of the asset, and the economic factors present would have permittedthis higher price regardless of the excuse given or the particular rationalization used. The pricecould have been increased without a higher depreciation charge.

The funds of a firm operating profitably do increase, but these may be used as working capitalpolicy may dictate. The measure of the increase in these funds from operations is not merely netincome, but that figure plus charges to operations which did not require working capital, lesscredits to operations which did not create working capital. The fact that net income alone does notmeasure the increase in funds from profitable operations leads some non-accountants to theerroneous conclusion that a fund is being created and that the amount of depreciation recordedaffects the fund accumulation.

Acceleration of depreciation for purposes of income tax calculation stands in a slightly differentcategory, since this is not merely a matter of recordkeeping. Increased depreciation will tend topostpone tax payments, and thus temporarily increase funds (although the liability for taxes maybe the same or even greater in the long run than it would have been) and generate gain to the firmto the extent of the value of use of the extra funds.

6. Assets are retired for one of two reasons: physical factors or economic factors—or a combinationof both. Physical factors are the wear and tear, decay, and casualty factors which hinder the assetfrom performing indefinitely. Economic factors can be interpreted to mean any other constraint thatdevelops to hinder the service life of an asset. Some accountants attempt to classify the economicfactors into three groups: inadequacy, supersession, and obsolescence. Inadequacy is defined asa situation where an asset is no longer useful to a given enterprise because the demands of thefirm have increased. Supersession is defined as a situation where the replacement of an assetoccurs because another asset is more efficient and economical. Obsolescence is the catchall termthat encompasses all other situations and is sometimes referred to as the major concept wheneconomic factors are considered.

7. Before the amount of the depreciation charge can be computed, three basic questions must beanswered:1. What is the depreciation base to be used for the asset?2. What is the asset’s useful life?3. What method of cost apportionment is best for this asset?

8. Cost $600,000 Cost $600,000

Depreciation rate 30%* Depreciation for 2006 (180,000)

Depreciation for 2006 $180,000 Undepreciated cost in 2007 420,000

Depreciation rate 30%

2006 Depreciation $180,000 Depreciation for 2007 $126,000

2007 Depreciation 126,000

Accumulated depreciation

at December 31, 2007 $306,000

*(1÷ 5) X 150%

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9. Depreciation base:

Cost $120,000 Straight-line, $105,000 ÷ 20 = $5,250

Salvage (15,000)

$105,000 Units-of-output, $105,000

84,000 X 20,000 = $25,000

Working hours, $105,000

42,000 X 14,300 = $35,750

Sum-of-the-years’-digits, $105,000 X 20/210* = $10,000

Declining-balance, $120,000 X 10% = $12,000

* 20(20 1)

2210

+=

10. From a conceptual point of view, the method which best matches revenue and expenses shouldbe used; in other words, the answer depends on the decline in the service potential of the asset. Ifthe service potential decline is faster in the earlier years, an accelerated method would seem to bemore desirable. On the other hand, if the decline is more uniform, perhaps a straight-line approachshould be used. Many firms adopt depreciation methods for more pragmatic reasons. Somecompanies use accelerated methods for tax purposes but straight-line for book purposes becausea higher net income figure is shown on the books in the earlier years, but a lower tax is paid to thegovernment. Others attempt to use the same method for tax and accounting purposes because iteliminates some recordkeeping costs. Tax policy sometimes also plays a role.

11. The composite method is appropriate for a company which owns a large number of heterogeneousplant assets and which would find it impractical to keep detailed records for them.

The principal advantage is that it is not necessary to keep detailed records for each plant asset inthe group. The principle disadvantage is that after a period of time the book value of the plantassets may not reflect the proper carrying value of the assets. Inasmuch as the accumulateddepreciation account is debited or credited for the difference between the cost of the asset and thecash received from the retirement of the asset (i.e., no gain or loss on disposal is recognized), theaccumulated depreciation account is self-correcting over time.

12. Cash ..................................................................................................................... 16,000Accumulated Depreciation—Plant Assets .................................................... 34,000

Plant Assets.................................................................................... 50,000No gain or loss is recognized under the composite method.

13. Original estimate: $2,400,000 ÷ 50 = $48,000 per yearDepreciation to January 1, 2007: $48,000 X 24 = $1,152,000Depreciation in 2007 ($2,400,000 – $1,152,000) ÷ 15 years = $83,200

14. No, depreciation does not provide cash; revenues do. The funds for the replacement of the assetscome from the revenues; without the revenues no income materializes and no cash inflow results.A separate decision must be made by management to set aside cash to accumulate assetreplacement funds. Depreciation is added to net income on the statement of cash flows (indirectmethod) because it is a noncash expense, not because it is a cash inflow.

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15. 25% straight-line rate X 2 = 50% double-declining rate$6,000 X 50% = $3,000 Depreciation for first full year.$3,000 X 6/12 = $1,500 Depreciation for half a year (first year), 2007$4,500 X 50% = $2,250 Depreciation for 2008.

16. The accounting standards require that if events or changes in circumstances indicate that thecarrying amount of such assets may not be recoverable, then the carrying amount of the assetshould be assessed. The assessment or review takes the form of a recoverability test thatcompares the sum of the expected future cash flows from the asset (undiscounted) to the carryingamount. If the cash flows are less than the carrying amount, the asset has been impaired. Theimpairment loss is measured as the amount by which the carrying amount exceeds the fair valueof the asset. The fair value of assets is measured by their market value if an active market forthem exists. If no market price is available, the present value of the expected future net cash flowsfrom the asset may be used.

17. Under U.S. GAAP, impairment losses on assets held for use may not be restored.

18. An impairment is deemed to have occurred if, in applying the recoverability test, the carryingamount of the asset exceeds the expected future net cash flows from the asset. In this case, theexpected future net cash flows of $705,000 exceed the carrying amount of the equipment of$700,000 so that no impairment is assumed to have occurred; thus no measurement of the loss ismade or recognized even though the fair value is $590,000.

19. Impairment losses are reported as part of income from continuing operations, generally in the “Otherexpenses and losses” section. Impairment losses (and recovery of losses for assets to be disposedof) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses)on assets to be disposed of should be reported as part of income from continuing operations.

20. In a decision to replace or not to replace an asset, the undepreciated cost of the old asset is not afactor to be considered. Therefore, the decision to replace plant assets should not be affected bythe amount of depreciation that has been recorded. The relative efficiency of new equipment ascompared with that presently in use, the cost of the new facilities, the availability of capital for thenew asset, etc., are the factors entering into the decision. Normally, the fact that the asset hadbeen fully depreciated through the use of some accelerated depreciation method, although theasset was still in use, should not cause management to decide to replace the asset. If the newasset under consideration for replacement was not any more efficient than the old, or if it cost agood deal more in relationship to its efficiency, it is illogical for management to replace it merelybecause all or the major portion of the cost had been charged off for tax and accounting purposes.

If depreciation rates were higher it might be true that a business would be financially more able toreplace assets, since during the earlier years of the asset’s use a larger portion of its cost wouldhave been charged to expense, and hence during this period a smaller amount of income tax paid.By a sale of the old asset, which might result in a capital gain, and purchase of a new asset, thehigher depreciation charge might be continued for tax purposes. However, if the asset were tradedin, having taken higher depreciation would result in a lower basis for the new asset.

It should be noted that expansion (not merely replacement) might be encouraged by increaseddepreciation rates. Management might be encouraged to expand, believing that in the first fewyears when they are reasonably sure that the expanded facilities will be profitable, they can chargeoff a substantial portion of the cost as depreciation for tax purposes. Similarly, since a replacementinvolves additional capital outlays, the tax treatment may have some influence.

Also, because of the inducement to expand or to start new businesses, there may be a tendencyin the economy as a whole for the accounting and tax treatment of the cost of plant assets toinfluence the retirement of old plant assets.

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It should be noted that to the extent that increased depreciation causes management to alter itsdecision about replacement, and to the extent it results in capital gains at the time of disposition, itis not matching costs and revenues in the closest possible manner.

21. In lieu of recording depreciation on replacement costs, management might elect to make annualappropriations of retained earnings in contemplation of replacing certain facilities at higher pricelevels. Such appropriations might help to eliminate misunderstandings as to amounts available fordistribution as dividends, higher wages, bonuses, or lower sales prices. The need for these appro-priations can be explained by supplementary financial schedules, explanations, and footnotesaccompanying the financial statements. (However, neither depreciation charges nor appropriationsof retained earnings result in the accumulation of funds for asset replacement. Fund accumulationis a result of profitable operations and appropriate funds management.)

22. (a) Depreciation and cost depletion are similar in the accounting sense in that:1. The cost of the asset is the starting point from which computation of the amount of the

periodic charge to operations is made.2. The estimated life is based on economic or productive life.3. The accumulated total of past charges to operations is deducted from the original cost of

the asset on the balance sheet.4 . When output methods of computing depreciation charges are used, the formulas are

essentially the same as those used in computing depletion charges.5. Both represent an apportionment of cost under the process of matching costs with revenue.6. Assets subject to either are reported in the same classification on the balance sheet.7. Appraisal values are sometimes used for depreciation while discovery values are sometimes

used for depletion.8. Residual value is properly recognized in computing the charge to operations.9. They may be included in inventory if the related asset contributed to the production of the

inventory.10. The rates may be changed upon revision of the estimated productive life used in the

original rate computations.(b) Depreciation and cost depletion are dissimilar in the accounting sense in that:

1. Depletion is almost always based on output whereas depreciation is usually based on time.2. Many formulas are used in computing depreciation but only one is used to any extent in

computing depletion.3. Depletion applies to natural resources while depreciation applies to plant and equipment.4. Depletion refers to the physical exhaustion or consumption of the asset while depreciation

refers to the wear, tear, and obsolescence of the asset.5. Under statutes which base the legality of dividends on accumulated earnings, depreciation

is usually a required deduction but depletion is usually not a required deduction.6. The computation of the depletion rate is usually much less precise than the computation of

depreciation rates because of the greater uncertainty in estimating the productive life.7. A difference that is temporary in nature arises from the timing of the recognition of depre-

ciation under conventional accounting and under the Internal Revenue Code, and it resultsin the recording of deferred income taxes. On the other hand, the difference between costdepletion under conventional accounting and its counterpart, percentage depletion, underthe Internal Revenue Code is permanent and does not require the recording of deferredincome taxes.

23. Cost depletion is the procedure by which the capitalized costs, less residual land values, of anatural resource are systematically charged to operations. The purpose of this procedure is tomatch the cost of the resource with the revenue it generates. The usual method is to divide thetotal cost less residual value by the estimated number of recoverable units to arrive at a depletioncharge for each unit removed. A change in the estimate of recoverable units will necessitate arevision of the unit charge.

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Percentage depletion is the procedure, authorized by the Internal Revenue Code, by which a certainpercentage of gross income is charged to operations in arriving at taxable income. Percentagedepletion is not considered to be a generally accepted accounting principle because it is notrelated to the cost of the asset and is allowed even though the property is fully depleted under costdepletion accounting. Applicable rates, ranging from 5% to 22% of gross income, are specified fornearly all natural resources. The total amount deductible in a given year may not be less than theamount computed under cost depletion procedures, and it may not exceed 50% of taxable incomefrom the property before the depletion deduction. Cost depletion differs from percentage depletion inthat cost depletion is a function of production whereas percentage depletion is a function of income.

Percentage depletion has arisen, in part, from the difficulty of valuing the natural resource ordetermining the discovery value of the asset and of determining the recoverable units. Althoughother arguments have been advanced for maintaining percentage depletion, a primary argument isits value in encouraging the search for additional resources. It is deemed to be in the nationalinterest to provide an incentive to the continuing search for natural resources. As noted in thetextbook, percentage depletion is no longer permitted for many enterprises.

24. This method does not necessarily measure the proper share of the cost of land to be charged toexpense for depletion and, in fact, may ultimately exceed the actual cost of the property.

25. The maximum permissible is the amount of accumulated net income (after depletion) plus theamount of depletion charged. This practice can be justified for companies that expect to extractnatural resources and not purchase additional properties. In effect, such companies are distributinggradually to stockholders their original investments.

26. Reserve recognition accounting (RRA) is the method that was proposed by the SEC to account foroil and gas resources. Proponents of this approach argue that oil and gas should be valued at thedate of discovery. The value of the reserve still in the ground is estimated and this amount,appropriately discounted, is reported on the balance sheet as “oil deposits.”

The costs of exploration incurred each year are deducted from the estimated reserves discoveredduring the same period with the difference probably being reported as income.

The oil companies are concerned because the valuation issue is extremely tenuous. For example, toproperly value the reserves, the following must be estimated: (1) amount of the reserves, (2) futureproduction costs, (3) periods of expected disposal, (4) discount rate, and (5) the selling price.

27. Using full-cost accounting, the cost of unsuccessful ventures as well as those that are successful arecapitalized, because a cost of drilling a dry hole is a cost that is needed to find the commerciallyprofitable wells. Successful efforts accounting capitalizes only those costs related to successfulprojects. They contend that to measure cost and effort accurately for a single property unit, the onlymeasure is in terms of the cost directly related to that unit. In addition, it is argued that full-cost ismisleading because capitalizing all costs will make an unsuccessful company over a short period oftime show no less income than does one that is successful.

28. Asset turnover ratio:

$45.7$29.8 = 1.5 times

Rate of return on assets:

$3.2$29.8 = 10.7%

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*29. The modified accelerated cost recovery system (MACRS) has been adopted by the InternalRevenue Service. It applies to depreciable assets acquired in 1987 and later. MACRS eliminatesthe need to determine each asset’s useful life. The selection of a depreciation method and asalvage value is also unnecessary under MACRS. The taxpayer determines the recovery deduc-tion for an asset by applying a statutory percentage to the historical cost of the property. MACRSwas adopted to permit a faster write-off of tangible assets so as to provide additional tax incentivesand to simplify the depreciation process. The simplification should end disputes related toestimated useful life, salvage value, and so on.

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SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 11-1

($42,000 – $2,000) X 23,0002007:

160,000= $5,750

($42,000 – $2,000) X 31,0002008:

160,000= $7,750

BRIEF EXERCISE 11-2

$60,000 – $6,000(a)

8= $6,750

$60,000 – $6,000(b)

8X 4/12 = $2,250

BRIEF EXERCISE 11-3

(a) ($60,000 – $6,000) X 8/36* = $12,000

(b) [($60,000 – $6,000) X 8/36] X 9/12 = $9,000

*[8(8 + 1)] ÷ 2

BRIEF EXERCISE 11-4

(a) $60,000 X 25%* = $15,000

(b) ($60,000 X 25%) X 3/12 = $3,750

*(1/8 X 2)

11-13

BRIEF EXERCISE 11-5

Depreciable Base = ($25,000 + $200 + $125 + $500 + $475) – $3,000 =$23,300.

BRIEF EXERCISE 11-6

Asset Depreciation ExpenseA ($70,000 – $7,000)/10 = $6,300B ($50,000 – $10,000)/5 = 8,000C ($82,000 – $4,000)/12 = 6,500

$20,800

Composite rate = $20,800/$202,000 = 10.3%Composite life = $181,000*/$20,800 = 8.7 years

*($63,000 + $40,000 + $78,000)

BRIEF EXERCISE 11-7

Annual depreciation expense: ($7,000 – $1,000)/5 = $1,200Book value, 1/1/08: $7,000 – (2 x $1,200) = $4,600Depreciation expense, 2008: ($4,600 – $500)/2 = $2,050

BRIEF EXERCISE 11-8

Recoverability test:Future net cash flows ($500,000) < Carrying amount ($540,000);

therefore, the asset has been impaired.

Journal entry:Loss on Impairment ............................................. 140,000 Accumulated Depreciation....................... 140,000 ($540,000 – $400,000)

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BRIEF EXERCISE 11-9

Inventory............................................................................ 72,625Accumulated Depletion...................................... 72,625

$400,000 + $100,000 + $75,000 – $160,0004,000

= $103.75 per ton

700 X $103.75 = $72,625

BRIEF EXERCISE 11-10

(a) Asset turnover ratio:$7,109

$6,205 + $6,675= 1.104 times

2

(b) Profit margin on sales:$647

$7,109= 9.1%

(c) Rate of return on assets:

(1) 1.104 X 9.1% = 10.05%

(2) $647$6,205 + $6,675

= 10.05%

2

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*BRIEF EXERCISE 11-11

2008: $40,000 X 20% = $ 8,0002009: $40,000 X 32% = 12,8002010: $40,000 X 19.2% = 7,6802011: $40,000 X 11.52% = 4,6082012: $40,000 X 11.52% = 4,6082013: $40,000 X 5.76% = 2,304

$40,000

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SOLUTIONS TO EXERCISES

EXERCISE 11-1 (15–20 minutes)

(a) Straight-line method depreciation for each of Years 1 through 3 =$469,000 – $40,000

12= $35,750

12 X 13(b) Sum-of-the-Years’-Digits =

2= 78

12/78 X ($469,000 – $40,000) = $66,000 depreciation Year 1



100%(c)

12X 2 = 16.67%Double-Declining Balance method

depreciation rate.

$469,000 X 16.67% = $78,182 depreciation Year 1

($469,000 – $78,182) X 16.67% = $65,149 depreciation Year 2

($469,000 – $78,182 – $65,149) X 16.67% = $54,289 depreciation Year 3


(a) If there is any salvage value and the amount is unknown (as is thecase here), the cost would have to be determined by looking at thedata for the double-declining balance method.

100%5

= 20%; 20% X 2 = 40%

Cost X 40% = $20,000$20,000 ÷ .40 = $50,000 Cost of asset

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EXERCISE 11-2 (Continued)

(b) $50,000 cost [from (a)] – $45,000 total depreciation = $5,000 salvagevalue.

(c) The highest charge to income for Year 1 will be yielded by the double-declining balance method.

(d) The highest charge to income for Year 4 will be yielded by thestraight-line method.

(e) The method that produces the highest book value at the end of Year 3would be the method that yields the lowest accumulated depreciationat the end of Year 3, which is the straight-line method.

Computations:St.-line = $50,000 – ($9,000 + $9,000 + $9,000) = $23,000 book value,end of Year 3.S.Y.D. = $50,000 – ($15,000 + $12,000 + $9,000) = $14,000 book value,end of Year 3.D.D.B. = $50,000 – ($20,000 + $12,000 + $7,200) = $10,800 book value,end of Year 3.

(f) The method that will yield the highest gain (or lowest loss) if the assetis sold at the end of Year 3 is the method which will yield the lowestbook value at the end of Year 3, which is the double-declining balancemethod in this case.


20 (20 + 1)(a)

2= 210

3/4 X 20/210 X ($711,000 – $60,000) = $46,500 for 2007

1/4 X 20/210 X ($711,000 – $60,000) = $15,500+ 3/4 X 19/210 X ($711,000 – $60,000) = 44,175

$59,675 for 2008

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100%(b)

20= 5%; 5% X 2 = 10%

3/4 X 10% X $711,000 = $53,325 for 2007

10% X ($711,000 – $53,325) = $65,768 for 2008


(a) $315,000 – $15,000 = $300,000; $300,000 ÷ 10 yrs. = $30,000

(b) $300,000 ÷ 240,000 units = $1.25; 25,500 units X $1.25 = $31,875

(c) $300,000 ÷ 25,000 hours = $12.00 per hr.; 2,650 hrs. X $12.00 = $31,800

n(n + 1) 10(11)(d) 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55 OR

2=

2= 55

1055

X $300,000 X 1/3 = $18,182

955

X $300,000 X 2/3 = 32,727

Total for 2008 $50,909

(e) $315,000 X 20% X 1/3 = $21,000

[$315,000 – ($315,000 X 20%)] X 20% X 2/3 = 33,600

Total for 2008 $54,600

[May also be computed as 20% of ($315,000 – 2/3 of 20% of $315,000)]

11-19


($117,900 – $12,900)(a)

5= $21,000/yr. = $21,000 X 5/12 = $8,750

2007 Depreciation—Straight line = $8,750

($117,900 – $12,900)(b)

21,000= $5.00/hr.

2007 Depreciation—Machine Usage = 800 X $5.00 = $4,000

(c) Machine Allocated to

Year Total 2007 2008

1 5/15 X $105,000 = $35,000 $14,583* $20,417**2 4/15 X $105,000 = $28,000 ______ 11,667***

$14,583 $32,084* $35,000 X 5/12 = $14,583

** $35,000 X 7/12 = $20,417*** $28,000 X 5/12 = $11,667

2008 Depreciation—Sum-of-the-Years’-Digits = $32,084

(d) 2007 40% X ($117,900) X 5/12 = $19,650

2008 40% X ($117,900 – $19,650) = $39,300

OR

1st full year (40% X $117,900) = $47,160

2nd full year [40% X ($117,900 – $47,160)] = $28,296

2007 Depreciation = 5/12 X $47,160 = $19,650

2008 Depreciation = 7/12 X $47,160 = $27,5105/12 X $28,296 = 11,790

$39,300

11-20


$212,000 – $12,000(a) 2006 Straight-line

8= $25,000/year

3 months—Depreciation $6,250 = ($25,000 X 3/12)

$212,000 – $12,000(b) 2006 Output

40,000= $5.00/output unit

1,000 units X $5.00 = $5,000

$212,000 – $12,000(c) 2006 Working hours

20,000= $10.00/hour

525 hours X $10.00 = $5,250

n (n + 1) 8(9)(d) 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 36 OR

2=

2= 36

Allocated to

Sum-of-the-years’-digits Total 2006 2007 2008

Year 1 8/36 X $200,000 = $44,444 $11,111 $33,3332 7/36 X $200,000 = $38,889 9,722 $29,1673 6/36 X $200,000 = $33,333 _______ _______ 8,333

$11,111 $43,055 $37,500

2008: $37,500 = (9/12 of 2nd year of machine’s life plus 3/12 of 3rd yearof machine’s life)

(e) Double-declining balance 2007: 1/8 X 2 = 25%.

2006: 25% X $212,000 X 3/12 = $13,250

2007: 25% X ($212,000 – $13,250) = $49,688

OR

1st full year (25% X $212,000) = $53,000

11-21


2nd full year [25% X ($212,000 – $53,000)] = $39,750

2006 Depreciation 3/12 X $53,000 = $13,250

2007 Depreciation 9/12 X $53,000 = $39,750 3/12 X $39,750 = 9,938

$49,688


Methods of Depreciation

Description

Date

Purchased Cost Salvage Life Method

Accum. Depr.

to 2007

2008 Depr.

A 2/12/06 $142,500 $16,000 10 (a) SYD $33,350 (b) $19,550

B 8/15/05 (c) 79,000 21,000 5 SL 29,000 (d) 11,600

C 7/21/04 75,400 23,500 8 DDB (e) 47,567 (f) 4,333

D (g) 10/12/06 219,000 69,000 5 SYD 70,000 (h) 35,000

Machine A—Testing the methodsStraight-Line Method for 2006 $ 6,325 [($142,500 – $16,000) ÷

10] X 1/2

Straight-Line Method for 2007 $12,650Total Straight Line $18,975

Double-Declining Balance for 2006 $14,250 ($142,500 X .2 X .5)

Double-Declining Balance for 2007 $25,650 [($142,500 – $14,250) X .2]

Total Double Declining Balance $39,900

Sum-of-the-years-digits for 2006 $11,500 [($142,500 – $16,000) X

10/55 X .5]

Sum-of-the-years-digits for 2007 $21,850 ($126,500 X 10/55 X 1/2) +

($126,500 X 9/55 X .5)

Total Sum-of-the-years-digits $33,350

Method used must be SYDUsing SYD, 2008 Depreciation is $19,550 ($126,500 X 9/55 X 1/2) +

($126,500 X 8/55 X .5)

11-22


Machine B—Computation of the costAsset has been depreciated for 2 1/2 years using the straight-linemethod.Annual depreciation is then equal to $29,000 divided by 2.5 or $11,600.11,600 times 5 plus the salvage value is equal to the cost.Cost is $79,000 [($11,600 X 5) + $21,000].

Using SL, 2008 Depreciation is $11,600.

Machine C—Using the double-declining balance method of depreciation2004’s depreciation is $ 9,425 ($75,400 X .25 X .5)2005’s depreciation is $16,494 ($75,400 – $9,425) X .252006’s depreciation is $12,370 ($75,400 – $25,919) X .252007’s depreciation is $ 9,278 ($75,400 – $38,289) X .25

$47,567

Using DDB, 2008 Depreciation is $4,333 ($75,400 – $47,567 – $23,500)

Machine D—Computation of Year PurchasedFirst Half Year using SYD = $25,000 [($219,000 – $69,000) X

5/15 X .5]

Second Year using SYD = $45,000 ($150,000 X 5/15 X .5) +

($150,000 X 4/15 X .5)

$70,000

Thus the asset must have been purchased on October 12, 2006

Using SYD, 2008 Depreciation is $35,000 ($150,000 X 4/15 X .5) +

($150,000 X 3/15 X .5)

11-23


Old Machine

June 1, 2005 Purchase $31,000Freight 200Installation 500

Total cost $31,700

Annual depreciation charge: ($31,700 – $2,500) ÷ 10 = $2,920

On June 1, 2006, debit the old machine for $1,980; the revised total costis $33,680 ($31,700 + $1,980); thus the revised annual depreciationcharge is: ($33,680 – $2,500 – $2,920) ÷ 9 = $3,140.

Book value, old machine, June 1, 2009: [$33,680 – $2,920 – ($3,140 X 3)] = $21,340Fair market value 20,000Loss on exchange 1,340Cost of removal 75

Total loss $ 1,415

(Note to instructor: The above computation is done to determine whetherthere is a gain or loss from the exchange of the old machine with the newmachine and to show how the cost of removal might be reported. Also, if again occurs, the gain is not deferred (1) because the exchange hascommercial substance and (2) the cost paid exceeds 25% of the total valueof the property received.)

New MachineBasis of new machine Cash paid ($35,000 – $20,000) $15,000

Fair market value of old machine 20,000Installation cost 1,500

Total cost of new machine $36,500

Depreciation for the year beginning June 1, 2009 = ($36,500 – $4,000) ÷ 10 =$3,250.

11-24


(a) Asset CostEstimatedSalvage

DepreciableCost

EstimatedLife

Depreciationper Year

A $ 40,500 $ 5,500 $ 35,000 10 $ 3,500B 33,600 4,800 28,800 9 3,200C 36,000 3,600 32,400 9 3,600D 19,000 1,500 17,500 7 2,500E 23,500 2,500 21,000 6 3,500

$152,600 $17,900 $134,700 $16,300

Composite life = $134,700 ÷ $16,300, or 8.26 yearsComposite rate = $16,300 ÷ $152,600, or approximately 10.7%

(b) Depreciation Expense—Plant Assets ................... 16,300Accumulated Depreciation—Plant Assets................................................................ 16,300

(c) Cash ................................................................................. 4,800Accumulated Depreciation—Plant Assets .......... 14,200

Plant Assets........................................................ 19,000


8 X 9Sum-of-the-years’-digits =

2= 36

Using Y to stand for the years of remaining life:

Y/36 X ($430,000 – $70,000) = $60,000

Multiplying both sides by 36:

$360,000 X Y = $2,160,000Y = $2,160,000 ÷ $360,000Y = 6

The year in which there are six remaining years of life at the beginning ofthat given year is 2006.

11-25


(a) No correcting entry is necessary because changes in estimate arehandled in the current and prospective periods.

(b) Revised annual chargeBook value as of 1/1/2008 [$60,000 – ($7,000 X 5)] = $25,000Remaining useful life, 5 years (10 years – 5 years)Revised salvage value, $4,500($25,000 – $4,500) ÷ 5 = $4,100

Depreciation Expense—Equipment .......................... 4,100Accumulated Depreciation—Equipment....... 4,100


(a) 1981–1990—($2,000,000 – $60,000) ÷ 40 = $48,500/yr.

(b) 1991–2008—Building ($2,000,000 – $60,000) ÷ 40 = $48,500/yr. Addition ($500,000 – $20,000) ÷ 30 = 16,000/yr.

$64,500/yr.

(c) No entry required.

(d) Revised annual depreciationBuilding

Book value: ($2,000,000 – $1,358,000*) $642,000Salvage value 60,000

582,000Remaining useful life 32 yearsAnnual depreciation $ 18,188

*$48,500 X 28 years = $1,358,000

11-26


AdditionBook value: ($500,000 – $288,000**) $212,000Salvage value 20,000

192,000Remaining useful life 32 yearsAnnual depreciation $ 6,000

**$16,000 X 18 years = $288,000

Annual depreciation expense—building ($18,188 + $6,000) $24,188


(a) $2,200,000 ÷ 40 = $55,000

(b) Loss on Disposal of Plant Assets .......................... 80,000Accumulated Depreciation—Building ($160,000 X 20/40)..................................................... 80,000

Building ................................................................ 160,000

Building........................................................................... 300,000Cash....................................................................... 300,000

Note: The most appropriate entry would be to remove the old roof andrecord a loss on disposal, because the cost of the old roof is given.Another alternative would be to debit Accumulated Depreciation onthe theory that the replacement extends the useful life of the building.The entry in this case would be as follows:

Accumulated Depreciation—Building................... 300,000Cash....................................................................... 300,000

As indicated, this approach does not seem as appropriate as the firstapproach.

11-27


(c) No entry necessary.

(d) (Assume the cost of the old roof is removed)Building ($2,200,000 – $160,000 + $300,000) $2,340,000Accumulated Depreciation ($55,000 X 20 – $80,000) 1,020,000

1,320,000Remaining useful life 25 yearsDepreciation—2008 ($1,320,000 ÷ 25) $ 52,800

OR(Assume the cost of the new roof is debited to accumulated depreciation)Book value of the building prior to the replacement of roof $2,200,000 – ($55,000 X 20) = $1,100,000Cost of new roof 300,000

$1,400,000Remaining useful life 25 yearsDepreciation—2008 ($1,400,000 ÷ 25) $ 56,000


(a) Repair Expense............................................................. 500Equipment............................................................ 500

(b) The proper ending balance in the asset account is:January 1 balance $134,750Add: New equipment: Purchases $32,000 Freight 700 Installation 2,700

35,400Less: Cost of equipment sold (23,000)December 31 balance $147,150

(1) Straight-line: $147,150 ÷ 10 = $14,715

11-28


(2) Sum-of-the-years’-digits: 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55

n(n + 1) 10(11)OR

2=

2= 55

For equipment purchased in 2006: $111,750 ($134,750 – $23,000) ofthe cost of equipment purchased in 2006, is still on hand.

8/55 X $111,750 = $16,255For equipment purchased in 2008: 10/55 X $35,400 = 6,436

Total $22,691


(a)

2002

2003–2008

Incl. 2009 Total

(1) $192,000 – $16,800 = $175,200

$175,200 ÷ 12 = $14,600

per yr. ($40 per day)

133*/365 of $14,600 = $ 5,320

2003–2008 Include. (6 X $14,600) $87,600

68/365 of $14,600 = $ 2,720 $ 95,640

(2) 0 87,600 14,600 102,200

(3) 14,600 87,600 0 102,200

(4) 7,300 87,600 7,300 102,200

(5) 4/12 of $14,600 4,867

2003–2008 Inc. 87,600

3/12 of $14,600 3,650 96,117

(6) 0 87,600 0 87,600

*(11 + 30 + 31 + 30 + 31)

(b) The most accurate distribution of cost is given by methods 1 and 5 ifit is assumed that straight-line is satisfactory. Reasonable accuracyis normally given by 2, 3, or 4. The simplest of the applications are 6,2, 3, 4, 5, and 1, in about that order. Methods 2, 3, and 4 combinereasonable accuracy with simplicity of application.

11-29


(a) December 31, 2007Loss on Impairment..................................................... 3,200,000

Accumulated Depreciation—Equipment.... 3,200,000

Cost $9,000,000Accumulated depreciation 1,000,000Carrying amount 8,000,000Fair value 4,800,000Loss on impairment $3,200,000

(b) December 31, 2008Depreciation Expense................................................. 1,200,000

Accumulated Depreciation—Equipment.... 1,200,000

New carrying amount $4,800,000Useful life 4 yearsDepreciation per year $1,200,000

(c) No entry necessary. Restoration of any impairment loss is not permitted.


(a) Loss on Impairment..................................................... 3,220,000Accumulated Depreciation—Equipment.... 3,220,000

Cost $9,000,000Accumulated depreciation 1,000,000Carrying amount 8,000,000Less: Fair value 4,800,000Plus: Cost of disposal 20,000Loss on impairment $3,220,000

11-30


(b) No entry necessary. Depreciation is not taken on assets intended tobe sold.

(c) Accumulated Depreciation—Equipment............. 500,000Recovery of Loss on Impairment................ 500,000

Fair value $5,300,000Less: Cost of disposal 20,000 5,280,000Carrying amount 4,780,000Recovery of impairment loss $ 500,000


(a) December 31, 2007Loss on Impairment .................................................... 270,000

Accumulated Depreciation—Equipment ... 270,000

Cost $900,000Accumulated depreciation 400,000Carrying amount 500,000Fair value 230,000Loss on impairment $270,000

(b) It may be reported in the other expenses and losses section or it maybe highlighted as an unusual item in a separate section. It is notreported as an extraordinary item.

(c) No entry necessary. Restoration of any impairment loss is not permitted.

(d) Management first had to determine whether there was an impairment.To evaluate this step, management does a recoverability test. Therecoverability test estimates the future cash flows expected from useof that asset and its eventual disposition. If the sum of the expectedfuture net cash flows (undiscounted) is less than the carrying amountof the asset, an impairment results. If the recoverability test indicatesthat an impairment has occurred, a loss is computed. The impairmentloss is the amount by which the carrying amount of the asset exceedsits fair value.

11-31


$84,000(a) Depreciation Expense:

30 years= $2,800 per year

Cost of Timber Sold: $1,400 – $400 = $1,000$1,000 X 9,000 acres = $9,000,000 of value of timber

($9,000,000 ÷ 3,500,000 bd. ft.) X 700,000 bd. ft. = $1,800,000

(b) Cost of Timber Sold: $9,000,000 – $1,800,000 = $7,200,000$7,200,000 + $100,000 = $7,300,000

($7,300,000 ÷ 5,000,000 bd. ft.) X 900,000 bd. ft. = $1,314,000

Note: The spraying costs as well as the costs to maintain the fire lanes androads are expensed each period and are not part of the depletion base.


Cost per barrel of oil:

$500,000Initial payment =

250,000= $2.00

$31,500Rental =

18,000= 1.75

Premium, 5% of $55 = 2.75

$30,000Reconditioning of land =

250,000= .12

Total cost per barrel $6.62

11-32


(a) $1,300 – $300 = $1,000 per acre for timber

$1,000 X 7,000 acres8,000 bd. ft. X 7,000 acres X 850,000 bd. ft. =

$7,000,00056,000,000 bd. ft. X 850,000 bd. ft. = $106,250.

$78,400(b) 56,000,000 bd. ft. X 850,000 bd. ft. = $1,190.

(c) Forda should capitalize the cost of $70,000 ($20 X 3,500 trees) andadjust the depletion the next time the timber is harvested.


Depletion base: $1,190,000 + $90,000 – $100,000 + $200,000 = $1,380,000

Depletion rate: $1,380,000 ÷ 60,000 = $23/ton

(a) Per unit material cost: $23/ton(b) 12/31/07 inventory: $23 X 8,000 tons = $184,000(c) Cost of goods sold 2007: $23 X 22,000 tons = $506,000


$970,000 + $170,000 + $40,000* – $100,000(a)12,000,000

= .09 depletion per unit

*Note to instructor: The $40,000 should be depleted because it is aasset retirement obligation.

2,500,000 units extracted X $.09 = $225,000 depletion for 2007

(b) 2,100,000 units sold X $.09 = $189,000 charged to cost of goods soldfor 2007

11-33


(a) Asset turnover ratio:

$13,516$14,846 + $14,737

= .914 times

2

(b) Rate of return on assets:

$556$14,846 + $14,737

= 3.76%

2

(c) Profit margin on sales:$556

$13,516= 4.11%

(d) The asset turnover ratio times the profit margin on sales provides therate of return on assets computed for Eastman Kodak as follows:

Profit margin on sales X Asset Turnover Return on Assets

4.11% X .914 = 3.76%

Note the answer 3.76% is the same as the rate of return on assetscomputed in (b) above.

11-34

*EXERCISE 11-25 (20–25 minutes)

2007 2008

(a) Revenues $200,000 $200,000Operating expenses (excluding depreciation) 130,000 130,000Depreciation [($27,000 – $6,000) ÷ 7] 3,000 3,000Income before income taxes $ 67,000 $ 67,000

2007 2008

(b) Revenues $200,000 $200,000Operating expenses (excluding depreciation) 130,000 130,000Depreciation* 5,400 8,640Taxable income $ 64,600 $ 61,360

*2007 $27,000 X .20 = $5,400 2008 $27,000 X .32 = $8,640

(c) Book purposes ($27,000 – $6,000) $21,000Tax purposes (entire cost of asset) $27,000

(d) Differences will occur for the following reasons:1. different depreciation methods.2. half-year convention used for tax purposes.3. estimated useful life and tax life different.4. tax system ignores salvage value.

*EXERCISE 11-26 (15–20 minutes)

(a) (1) ($31,000 – $1,000) X 1/10 X 10/12 = $2,500 depreciation expensefor book purposes.

(2) $31,000 X 1/5 X 1/2 = $3,100 depreciation for tax purposes.

11-35

*EXERCISE 11-26 (Continued)

(b) (1) $31,000 X 20% X 10/12 = $5,167 depreciation expense for bookpurposes.

(2) $31,000 X 40% X 1/2 = $6,200 depreciation expense for taxpurposes.

(c) Differences will occur for the following reasons:1. half-year convention used for tax purposes.2. estimated useful life and tax life different.3. tax system ignores salvage value.

11-36

TIME AND PURPOSE OF PROBLEMS

Problem 11-1 (Time 25–30 minutes)Purpose—to provide the student with an opportunity to compute depreciation expense using a numberof different depreciation methods. The problem is complicated because the proper cost of the machineto be depreciated must be determined. For example, purchase discounts and freight charges must beconsidered. In addition, the student is asked to select a depreciation method that will allocate lessdepreciation in the early years of the machine’s life than in the later years.

Problem 11-2 (Time 25–35 minutes)Purpose—to provide the student with an opportunity to compute depreciation expense using thefollowing methods: straight-line, units-of-output, working hours, sum-of-the-years’-digits, and decliningbalance. The problem is straightforward and provides an excellent review of the basic computationalissues involving depreciation methods.

Problem 11-3 (Time 40–50 minutes)Purpose—to provide the student with an opportunity to compute depreciation expense using a numberof different depreciation methods. Before the proper depreciation expense can be computed, theaccounts must be corrected for a number of errors made by the company in its accounting for theassets. An excellent problem for reviewing the proper accounting for plant assets and related deprecia-tion expense.

Problem 11-4 (Time 45–60 minutes)Purpose—to provide the student with an opportunity to correct the improper accounting for Semitrucksand determine the proper depreciation expense. The student is required to compute separately theerrors arising in determining or entering depreciation or in recording transactions affecting Semitrucks.

Problem 11-5 (Time 25–30 minutes)Purpose—to provide the student with a problem involving the computation of estimated depletion anddepreciation costs associated with a tract of mineral land. The student must compute depletion anddepreciation on a units-of-production basis (tons mined). A portion of the cost of machinery associatedwith the product must be allocated over different periods. The student may experience some difficultywith this problem.

Problem 11-6 (Time 25–30 minutes)Purpose—to provide the student with a problem involving the proper accounting for depletion cost. Thisproblem involves timberland for which a depletion charge must be computed. In addition, a computationof a loss that occurs because of volcanic activity must be determined.

Problem 11-7 (Time 25–35 minutes)Purpose—to provide the student with a problem involving depletion and depreciation computations.

Problem 11-8 (Time 25–35 minutes)Purpose—to provide the student with a comprehensive problem related to property, plant, andequipment. The student must determine depreciable bases for assets, including capitalized interest,and prepare depreciation entries using various methods of depreciation.

Problem 11-9 (Time 15–25 minutes)Purpose—to provide the student with an opportunity to analyze impairments for assets to be used andassets to be disposed of.

Problem 11-10 (Time 45–60 minutes)Purpose—to provide the student with an opportunity to solve a complex problem involving a number ofplant assets. A number of depreciation computations must be made, specifically straight-line, 150%declining balance, and sum-of-the-years’-digits. In addition, the cost of assets acquired is difficult todetermine.

11-37

Time and Purpose of Problems (Continued)

Problem 11-11 (Time 30–35 minutes)Purpose—to provide the student with the opportunity to solve a moderate problem involving a machinerypurchase and the depreciation computations using straight-line, activity, sum-of-the-years’-digits, andthe double-declining balance methods, first for full periods and then for partial periods.

*Problem 11-12 (Time 25–35 minutes)Purpose—to provide the student with an opportunity to compute depreciation expense using a numberof different depreciation methods. The purpose of computing the depreciation expense is to determinewhich method will result in the maximization of net income and which will result in the minimization ofnet income over a three-year period. An excellent problem for reviewing the fundamentals of depreciationaccounting.

11-38

SOLUTIONS TO PROBLEMS

PROBLEM 11-1

(a) (1) Depreciable Base Computation:Purchase price $73,500Less: Purchase discount (2%) (1,470)Freight-in 970Installation 3,800

76,800Less: Salvage value 1,200Depreciation base $75,600

2007—Straight line: ($75,600 ÷ 8 years) X 2/3 year = $6,300

(2) Sum-of-the-years’-digits for 2008

Machine YearTotal

Depreciation 2007 20081 8/36 X $75,600 = $16,800 $11,200* $ 5,600**2 7/36 X $75,600 = $14,700 9,800***

$15,400

* $16,800 X 2/3 = $11,200** $16,800 X 1/3 = $5,600

*** $14,700 X 2/3 = $9,800

(3) Double-declining balance for 2007 ($76,800 X 25% X 2/3) = $12,800

(b) An activity method.

11-39

PROBLEM 11-2

DepreciationExpense

2007 2008(a) Straight-line:

($67,000 – $4,000) ÷ 7 = $9,000/yr. 2007: $9,000 X 7/12 $5,250 2008: $9,000 $9,000

(b) Units-of-output: ($67,000 – $4,000) ÷ 525,000 units = $.12/unit 2007: $.12 X 55,000 6,600 2008: $.12 X 48,000 5,760

(c) Working hours: ($67,000 – $4,000) ÷ 42,000 hrs. = $1.50/hr. 2007: $1.50 X 6,000 9,000 2008: $1.50 X 5,500 8,250

(d) Sum-of-the-years’-digits:

n(n + 1) 7(8)1 + 2 + 3 + 4 + 5 + 6 + 7 = 28 or 2 = 2 = 28

2007: 7/28 X $63,000 X 7/12 9,188 2008: 7/28 X $63,000 X 5/12 = $6,563 6/28 X $63,000 X 7/12 = 7,875

$14,438 14,438

(e) Declining balance: Rate = 2/7 2007: 7/12 X 2/7 X $67,000 11,167 2008: 2/7 X ($67,000 – $11,167) = $15,952

OR 2008: 5/12 X 2/7 X $67,000 = $ 7,976 2/7 X ($67,000 – $19,143) X 7/12 7,976

$15,952 15,952

11-40

PROBLEM 11-3

(a) Depreciation Expense—Asset A.................................... 2,900Accumulated Depreciation—Asset A................ 2,900 (5/55 X [$35,000 – $3,100])

Accumulated Depreciation—Asset A........................... 26,100Asset A ($35,000 – $13,000).................................. 22,000Gain on Disposal of Plant Assets....................... 4,100

(b) Depreciation Expense—Asset B.................................... 6,720Accumulated Depreciation—Asset B................ 6,720 ([$51,000 – $3,000] ÷ 15,000 X 2,100)

(c) Depreciation Expense—Asset C.................................... 6,000Accumulated Depreciation—Asset C................ 6,000 ([$80,000 – $15,000 – $5,000] ÷ 10)

(d) Asset E ................................................................................... 22,000Retained Earnings ................................................... 22,000

Depreciation Expense—Asset E.................................... 4,400*Accumulated Depreciation—Asset E ................ 4,400

*($22,000 X .20)

11-41

PROBLEM 11-4

Net

Inco

me

Ove

rsta

ted

(Un

der

stat

ed)

$

2,0

00

(1,1

00)

100

(5,1

00)

7,

100

(9

,450

)

(13

,800

)

1 2 3 4 5 6 7

Ret

ain

edE

arn

ing

sd

r, (

cr.)

$ 2

,000

19,

200

100

16,

000

6,40

0

15,

000

14,

000

Acc

. Dep

.,S

emit

ruck

sd

r, (

cr.)

$(30

,200

)

9

,000

(19,

200)

(40,

400)

14

,400

(16

,000

)(4

2,00

0)

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11-42

PROBLEM 11-4 (Continued)

3Book value of Truck #1 [$18,000 – ($18,000/5 X 4 yrs.)] =$18,000 – $14,400 = $3,600

Cash received on sale = 3,500Loss on sale $ 100

4Truck #2: $22,000/5 = $4,400 Truck #4: $24,000/5 = 4,800 Truck #5: $34,000/5 = 6,800

Total $16,000

5Book value of Truck #4 $24,000 – [($24,000/5 X 3 yrs.)] = $9,600Cash received ($700 + $2,500) = 3,200

Loss on disposal $6,400

6Truck #2: $22,000/5 X 1/2 = $ 2,200 Truck #4: $24,000/5 X 1/2 = 2,400 Truck #5: $34,000/5 6,800 Truck #6: $36,000/5 X 1/2 = 3,600

Total $15,000

7Truck #2: (fully dep.) = $ 0 Truck #5: $34,000/5 = 6,800 Truck #6: $36,000/5 = 7,200

Total $14,000

(b) Compound journal entry December 31, 2008:Accumulated Depreciation, Semitrucks...................... 67,250

Semitrucks ................................................................. 47,000Retained Earnings ................................................... 6,450Depreciation Expense 2008 .................................. 13,800

11-43


Summary of Adjustments:

PerBooks

AsAdjusted

AdjustmentDr. or (Cr.)

Semitrucks $139,000 $92,000 $(47,000)

Accumulated Depreciation $123,850 $56,600 $ 67,250

Prior Years’ Income Retained Earnings, 2005 $ 20,300 $21,200 $ 900 Retained Earnings, 2006 21,100 16,100 (5,000) Retained Earnings, 2007 23,750 21,400 (2,350) Totals $ 65,150 $58,700 $ (6,450)

Depreciation Expense, 2008 $ 27,800 $14,000 $(13,800)

11-44

PROBLEM 11-5

(a) Estimated depletion:

Estimated Depletion

DepletionBase

EstimatedYield

PerTon

1ST & 11th

Yrs.Each of Yrs.

2-10 Incl.

$570,000* 120,000 tons $4.75 $28,500** $57,000***

* ($600,000 – $30,000)** ($4.75 X 6,000)

*** ($4.75 X 12,000)

Estimated depreciation:

Asset Cost

Per ton

Mined

1st

Yr.

Yrs.

2-5

6th

Yr.

Yrs.

7-10

11th

Yr.

Building $36,000 $.30* $1,800 $3,600 $3,600 $3,600 $1,800

Machinery (1/2) 24,000 .20** 1,200 2,400 2,400 2,400 1,200

Machinery (1/2) 24,000 .40*** 2,400 4,800 2,400 0 0

* $36,000 ÷ 120,000 = $.30** $24,000 ÷ 120,000 = $.20

*** $24,000 ÷ (120,000 X 1/2) = $.40

(b) Depletion: $4.75 X 7,000 tons = $33,250

Depreciation: Building $.30 X 7,000 = $2,100Machinery $.20 X 7,000 = 1,400Machinery $.40 X 7,000 = 2,800 Total depreciation $6,300

11-45

PROBLEM 11-6

(a) Original cost $550 X 3,000 = $1,650,000Deduct residual value of land $200 X 3,000 = 600,000

1,050,000Cost of logging road 150,000Depletion base $1,200,000

$1,200,000500,000 ft.

= $2.40 depletion per board foot

(b) Inventory ................................................................................ 240,000Accumulated Depreciation—Timber .................. 240,000

Depletion, 1980: 20% X 500,000 bd. ft. = 100,000 bd. ft.; 100,000 bd. ft. X $2.40 = $240,000

(c) Loss of timber [$1,050,000 – ($1,050,000 X 20%)] $840,000Loss of land value 600,000Loss of logging roads [($150,000 – (20% X $150,000)] 120,000Logging equipment 300,000Cost of salvaging timber 700,000Less recovery ($3 X 400,000 bd. ft.) (1,200,000)Extraordinary loss due to the eruption of Mt. St. Helens $1,360,000

11-46

PROBLEM 11-7

Instructors should note the changing depletion base in this problem.

2008Computation of Depletion Base for 2008TimberCost per acre $1,700Land Cost 800Timber Cost $ 900 X 10,000 acres $9,000,000Road Cost 195,000Total Depletion Base $9,195,000

Estimated Depletion for 2008 $9,195,000X 0.07 (472,500/6,750,000)

Depletion Expense for 2008 $ 643,650

Depreciation of Removable EquipmentCost $189,000Salvage Value (9,000)Depreciable base $180,000

Annual Depreciation using SL ($180,000/15) $ 12,000

Depreciation Expense for 2008 $ 5,000 (5/12 X $12,000)

11-47


2009Depletion Base for 2009

Base for 2008 $9,195,000Less Depletion for 2008 (643,650)Plus Seedling Planting Costs 120,000

Depletion Base for 2009 $8,671,350

Depletion Base for 2009 $8,671,350Times X 0.12 (774,000/6,450,000)Depletion for 2009 $1,040,562

Depreciation Expense for 2009 $ 12,000

2010Depletion Base for 2010

Base for 2009 $ 8,671,350Less: Depletion for 2009 (1,040,562)Plus: Seedling Planting Costs 150,000

Depletion Base for 2010 $ 7,780,788

Depletion Base for 2010 $ 7,780,788Times X .10 (650,000/6,500,000)Depletion for 2010 $ 778,079

Depreciation Expense for 2010 $ 12,000

11-48

PROBLEM 11-8

(a) The amounts to be recorded on the books of Selig Sporting GoodsInc. as of December 31, 2006, for each of the properties acquired fromStarks Athletic Equipment Company are calculated as follows:

Cost Allocations to Acquired Properties

Appraisal

Value

Remaining

Purchase

Price

Allocations Renovations

Capitalized

Interest Total

(1) Land $280,000 $280,000

(2) Building $ 84,0001 $100,000 $21,6002 205,600

(3) Machinery _______ 36,0001 _______ ______ 36,000

Totals $280,000 $120,000 $100,000 $21,600 $521,600

Supporting Calculations

1Balance of purchase price to be allocated.Total purchase price $400,000Less: Land appraisal 280,000

Balance to be allocated $120,000

AppraisalValues Ratios

AllocatedValues

Building $105,000 105/150 = .70 X $120,000 $ 84,000Machinery 45,000 45/150 = .30 X $120,000 36,000

Totals $150,000 1.00 $120,000

11-49


2Capitalizable interest.Expenditures

Date AmountCapitalization

PeriodWeighted-Average

Accumulated Expenditures

1/1 $ 50,000 12/12 $ 50,0004/1 130,000 9/12 97,50010/1 130,000 3/12 32,50012/31 190,000 0/12 - 0 -

$500,000 $180,000

Weighted-Average Interest AvoidableAccumulated Expenditures Rate Interest

$180,000 X 12% = $21,600

Note to instructor: If the interest is allocated between the building and themachinery, $15,120 ($21,600 X 105/150) would be allocated to the buildingand $6,480 ($21,600 X 45/150) would be allocated to the machinery.

(b) Selig Sporting Goods Inc.’s 2007 depreciation expense, for bookpurposes, for each of the properties acquired from Starks AthleticEquipment Company is as follows:

1. Land: No depreciation.

2. Building: Depreciation rate = 1.50 X 1/15 = .10 2007 depreciation expense = Cost X Rate X 1/2 year

= $205,600 X .10 X 1/2= $10,280

3. Machinery: Depreciation rate = 2.00 X 1/5 = .40 2007 depreciation expense = Cost X Rate X 1/2

= $36,000 X .40 X 1/2= $7,200

11-50


(c) Arguments for the capitalization of interest costs include thefollowing.

(1) Diversity of practices among companies and industries calledfor standardization in practices.

(2) Total interest costs should be allocated to enterprise assets andoperations, just as material, labor, and overhead costs areallocated. That is, under the concept of historical costs, all costsincurred to bring an asset to the condition and locationnecessary for its intended use should be reflected as a cost ofthat asset.

Arguments against the capitalization of interest include the following:

(1) Interest capitalized in a period would tend to be offset byamortization of interest capitalized in prior periods.

(2) Interest cost is a cost of financing, not of construction.

11-51

PROBLEM 11-9

(a) Carrying value of asset: $8,000,000 – $2,000,000* = $6,000,000.

*($8,000,000 ÷ 8) X 2

Future cash flows ($5,300,000) < Carrying value ($6,000,000)

Impairment entry:Loss on Impairment ........................................................ 1,600,000*

Accumulated Depreciation ................................ 1,600,000

*$6,000,000 – $4,400,000

(b) Depreciation Expense .................................................... 1,100,000**Accumulated Depreciation ................................ 1,100,000

**($4,400,000 ÷ 4)

(c) No depreciation is recorded on impaired assets to be disposed of.Recovery of impairment losses are recorded.

Loss on Impairment ........................................................ 1,600,000Accumulated Depreciation ................................ 1,600,000

12/31/09 Accumulated Depreciation....................... 200,000Recovery of Impairment Loss........ 200,000

11-52

PROBLEM 11-10

(1) $82,000 Allocated in proportion to appraised values (1/10 X $820,000).

(2) $738,000 Allocated in proportion to appraised values (9/10 X $820,000).

(3) Forty years Cost less salvage ($738,000 – $40,000) divided by annual depreciation ($17,450).

(4) $17,450 Same as prior year since it is straight-line depreciation.

(5) $91,000 [Number of shares (2,500) times fair value ($30)] plus demolition cost of existing building ($16,000).

(6) None No depreciation before use.

(7) $30,000 Fair market value.

(8) $4,500 Cost ($30,000) times percentage (1/10 X 150%).

(9) $3,825 Cost ($30,000) less prior year’s depreciation ($4,500) equals $25,500. Multiply $25,500 times 15%.

(10) $150,000 Total cost ($164,900) less repairs and maintenance ($14,900).

(11) $32,000 Cost less salvage ($150,000 – $6,000) times 8/36.

(12) $9,333 Cost less salvage ($150,000 – $6,000) times 7/36 times one-third of a year.

11-53


(13) $52,000 Annual payment ($6,000) times present value of annuitydue at 8% for 11 years (7.710) plus down payment($5,740). This can be found in an annuity due table sincethe payments are at the beginning of each year.Alternatively, to convert from an ordinary annuity to anannuity due factor, proceed as follows: For elevenpayments use the present value of an ordinary annuityfor 11 years (7.139) times 1.08. Multiply this factor(7.710) times $6,000 annual payment to obtain $46,260,and then add the $5,740 down payment.

(14) $2,600 Cost ($52,000) divided by estimated life (20 years).

11-54

PROBLEM 11-11

$77,000 – $5,000(a) (1) Straight-line Method:

5 years= $14,400 a year

$77,000 – $5,000(2) Activity Method:

100,000 hours= $.72 per hour

Year 2005 20,000 hrs. X $.72 = $14,4002006 25,000 hrs. X $.72 = 18,0002007 15,000 hrs. X $.72 = 10,8002008 30,000 hrs. X $.72 = 21,6002009 10,000 hrs. X $.72 = 7,200

(3) Sum-of-the-Years’-Digits: 5 + 4 + 3 + 2 + 1 = 15

Year 2005 5/15 X ($77,000 – $5,000) = $24,0002006 4/15 X $72,000 = 19,2002007 3/15 X $72,000 = 14,4002008 2/15 X $72,000 = 9,6002009 1/15 X $72,000 = 4,800

(4) Double-Declining Balance Method: Each year is 20% of its totallife. Double the rate to 40%.

Year 2005 40% X $77,000 = $30,8002006 40% X ($77,000 – $30,800) = 18,4802007 40% X ($77,000 – $49,280) = 11,0882008 40% X ($77,000 – $60,368) = 6,6532009 Enough to reduce to salvage = 4,979

11-55


(b) (1) Straight-line Method:

$77,000 – $5,000Year 2005

5 yearsX 9/12 = $10,800

2006 Full year 14,4002007 Full year 14,4002008 Full year 14,4002009 Full year 14,4002010 Full year X 3/12 year = 3,600

(2) Sum-of-the-Years’-Digits:

2005 (5/15 X $72,000) X 9/12 = $18,000

2006 (5/15 X $72,000) X 3/12 = $ 6,000(4/15 X $72,000) X 9/12 = 14,400 20,400

2007 (4/15 X $72,000) X 3/12 = 4,800(3/15 X $72,000) X 9/12 = 10,800 15,600

2008 (3/15 X $72,000) X 3/12 = 3,600(2/15 X $72,000) X 9/12 = 7,200 10,800

2009 (2/15 X $72,000) X 3/12 = 2,400(1/15 X $72,000) X 9/12 = 3,600 6,000

2010 (1/15 X $72,000) X 3/12 = 1,200

11-56


(3) Double-Declining Balance Method:

Year Cost

Accum.Depr. atbeg. of

year

BookValue atbeg. of

yearDepr.

Expense

2005 $77,000 — $77,000 $23,100 (1)2006 77,000 $23,100 53,900 21,560 (2)2007 77,000 44,660 32,340 12,936 (3)2008 77,000 57,596 19,404 7,762 (4)2009 77,000 65,358 11,642 4,657 (5)2010 77,000 70,015 6,985 1,985 (6)

(1) $77,000 X 40% X 9/12(2) ($77,000 – $23,100) X 40%(3) ($77,000 – $44,660) X 40%(4) ($77,000 – $57,596) X 40%(5) ($77,000 – $63,358) X 40%(6) to reduce to $5,000 salvage value.

11-57

*PROBLEM 11-12

(a) The straight-line method would provide the highest total net incomefor financial reporting over the three years, as it reports the lowesttotal depreciation expense. These computations are provided below.

Computations of depreciation expense and accumulated depreciationunder various assumptions:

(1) Straight-line:

$1,100,000 – $50,0005 years

= $210,000

YearDepreciation

ExpenseAccumulatedDepreciation

2005 $210,000 $ 210,0002006 210,000 $ 420,0002007 210,000 $ 630,000

$630,000

(2) Double-declining balance:

YearDepreciation


2005 $440,000 (40% X $1,100,000) $ 440,0002006 264,000 (40% X $660,000) $ 704,0002007 158,400 (40% X $396,000) $ 862,400

$862,400

(3) Sum-of-the-years’-digits:

YearDepreciation


2005 $350,000 (5/15 X $1,050,000) $ 350,0002006 280,000 (4/15 X $1,050,000) $ 630,0002007 210,000 (3/15 X $1,050,000 $ 840,000

$840,000

11-58

*PROBLEM 11-12 (Continued)

(4) Units-of-output:

YearDepreciation


2005 $252,000 ($21* X 12,000) $ 252,0002006 231,000 ($21 X 11,000) $ 483,0002007 210,000 ($21 X 10,000) $ 693,000

$693,000

*$1,050,000 ÷ 50,000 = $21 per unit

(b) General MACRS method:

Total CostMACRS

Rates (%)*Annual

DepreciationAccumulatedDepreciation

2005 $1,100,000 X 14.29 = $157,190 $157,1902006 1,100,000 X 24.49 = 269,390 $426,5802007 1,100,000 X 17.49 = 192,390 $618,970

$618,970

*Taken from the MACRS rates schedule.

Optional straight-line method:

Total CostDepreciation

RateAnnual

DepreciationAccumulatedDepreciation

2005 $1,100,000 X (1/7 X 1/2) = $ 78,571 $ 78,5712006 1,100,000 X 1/7 = 157,143 $235,7142007 1,100,000 X 1/7 = 157,143 $392,857

$392,857

The general MACRS method would have higher depreciation expense($618,970) than that of the optional straight-line method ($392,857) for thethree-year period ending December 31, 2007. Therefore, the generalMACRS method would minimize net income for income tax purposes forthis period.

11-59

TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS

CA 11-1 (Time 25–35 minutes)Purpose—to provide the student with an understanding of the basic objective of depreciation accounting.In addition, the case involves a reverse sum-of-the-years’-digits situation and the student is to commenton the propriety of such an approach. Finally, the classic issue of whether depreciation provides fundsmust be considered. The tax effects of depreciation must be considered when this part of the case isexamined. An excellent case for covering the traditional issues involving depreciation accounting.

CA 11-2 (Time 20–25 minutes)Purpose—to provide the student with a basic understanding of the difference between the unit andgroup or composite depreciation methods. The student is required to indicate the arguments for andagainst these methods and to indicate how retirements are handled.

CA 11-3 (Time 25–35 minutes)Purpose—to provide the student with an understanding of a number of unstructured situations involvingdepreciation accounting. The first situation considers whether depreciation should be recorded during astrike. The second situation involves the propriety of employing the units of production method incertain situations. The third situation involves the step-up of depreciation charges because propertiesare to be replaced due to obsolescence. The case is somewhat ambiguous, so cut-and-dried approachesshould be discouraged.

CA 11-4 (Time 30–40 minutes)Purpose—to provide the student with an understanding of the objectives of depreciation and thetheoretical basis for accelerated depreciation methods.

CA 11-5 (Time 20–25 minutes)Purpose—to provide the student with the opportunity to examine the ethical dimensions of thedepreciation method choice.

11-60

SOLUTIONS TO CONCEPTS FOR ANALYSIS

CA 11-1

(a) The purpose of depreciation is to distribute the cost (or other book value) of tangible capitalassets, less salvage, over their useful lives in a systematic and rational manner. Under generallyaccepted accounting principles as presently understood, depreciation accounting is a processof allocation, not of valuation, through which the productive effort (cost) is to be matched withproductive accomplishment (revenue) for the period. Depreciation accounting, therefore, isconcerned with the timing of the expiration of the cost of tangible plant assets.

(b) The proposed depreciation method is, of course, systematic. Whether it is rational in terms of costallocation depends on the facts of the case. It produces an increasing depreciation charge, whichis usually not justifiable in terms of the benefit from the use of the asset because manufacturerstypically prefer to use their new equipment as much as possible and their old equipment only asneeded to meet production quotas during periods of peak demand. As a general rule, then, thebenefit declines with age. Assuming that the actual operations (including equipment usage) ofeach year are identical, maintenance and repair costs are likely to be higher in the later years ofusage than in the earlier years. Hence the proposed method would couple light depreciation andrepair charges in the early years. Reported net income in the early years would be much higherthan reported net income in the later years of asset life, an unreasonable and undesirable variationduring periods of identical operation.

On the other hand, if the expected level of operations (including equipment usage) in the earlyyears of asset life is expected to be low as compared to that of later years because of slackdemand or production policies, the pattern of the depreciation charges of the proposed methodapproximately parallels expected benefits (and revenues) and hence is reasonable. Although theunits-of-production depreciation method is the usual selection to fit this case, the proposed methodalso conforms to generally accepted accounting principles in this case provided that properjustification is given.

(c) (1) Depreciation charges neither recover nor create funds. Revenue-producing activities are thesources of funds from operations: if revenues exceed out-of-pocket costs during a fiscalperiod, funds are available to cover other than out-of-pocket costs; if revenues do not exceedout-of-pocket costs, no funds are made available no matter how much, or little, depreciationis charged.

(2) Depreciation may affect funds in two ways. First, depreciation charges affect reported incomeand hence may affect managerial decisions such as those regarding pricing, product selection,and dividends. For example, the proposed method would result initially in higher reportedincome than would the straight-line method, consequently stockholders might demand higherdividends in the earlier years than they would otherwise expect.

The straight-line method, by causing a lower reported income during the early years of asset life andthereby reducing the amount of possible dividends in early years as compared with the proposed method,could encourage earlier reinvestments in other profit-earning assets in order to meet increasing demand.

Second, depreciation charges affect reported taxable income and hence affect directly the amount ofincome taxes payable in the year of deduction.

Using the proposed method for tax purposes would reduce the total tax bill over the life of the assets(1) if the tax rates were increased in future years or (2) if the business were doing poorly now but wereto do significantly better in the future. The first condition is political and speculative but the secondcondition may be applicable to Prophet Manufacturing Company in view of its recent origin and its rapidexpansion program. Consequently, more funds might be available for reinvestment in plant assets inyears of large deductions if one of the above assumptions were true.

11-61

CA 11-1 (Continued)

If Prophet is not profitable now, it would not benefit from higher deductions now and should consider anincreasing charge method for tax purposes, such as the one proposed. If Prophet is quite profitablenow, the president should reconsider his proposal because it will delay the availability of the tax shieldprovided by depreciation. However, this decision should not affect the decision to use a depreciationmethod for stockholders’ reporting that is systematic and rational in terms of cost allocation undergenerally accepted accounting principles as presently understood.

CA 11-2

(a) (1) The unit method of recording depreciation involves the treatment of plant assets or substantialadditions thereto as individual items. The method entails maintaining detailed records of thecosts of specific assets and related accumulated depreciation. Computation of depreciation isbased on the estimated useful life of the individual asset. The method is distinguished fromgroup and composite-life methods under which the cost and estimated life of the assets arecommingled. Depreciation may be recorded by straight-line, accelerated, or other acceptedcomputation methods.

(2) Under the group or composite-life methods, assets are aggregated into accounting units. Suchgrouping might be horizontal, vertical, or geographical. Horizontal grouping assemblestogether all assets of similar physical characteristics, such as trucks, presses, returnable con-tainers, etc. A vertical or functional grouping comprises all assets contributing to a commoneconomic function, such as a sugar refinery, a service station, etc. The geographical groupingincludes all assets in a district or region, such as telephone poles.

Depreciation under these methods requires development of a weighted-average rate from theassets’ depreciable costs and estimated lives. Separate accounts are established for the total costof each asset grouping and its related accumulated depreciation. The asset grouping should becomposed of a large number of units to obtain a reliable average life.

(b) 1. Arguments for the use of the unit method are:i. The method is simple in that it does not require involved mathematical computations.ii. The gain or loss on the retirement of a particular asset can be computed.iii. For cost purposes, depreciation on idle equipment can be isolated.iv. The method results in a more accurately computed depreciation provision in any given

year, as the total depreciation charge represents the best estimate of the depreciation ofeach asset and is not the result of averaging the cost over a longer period of time.

Arguments against the unit method are:i. Considerable additional bookkeeping is necessary to account for each asset and its

related depreciation. (The advent of computers reduces the work burden, however.)ii. There is a point of diminishing returns in the accumulation of accounting data under this

method, that is, additional accuracy may not justify the additional cost of record-keeping.iii. Under a decentralized financial control system where a measure of the division’s

efficiency is the rate of return on the gross book value of the investment a divisionmanager might scrap fully or nearly fully depreciated equipment to improve the division’srate of return even though the equipment is still serviceable.

iv. There may be reluctance on the part of a division manager to replace equipment notfully depreciated with more efficient equipment because of the effect of the loss on thedivision’s profits in the year of replacement.

2. Arguments for the use of the group and composite-life methods are:i. The methods require less detailed bookkeeping.i i . The application of depreciation to the whole group tends to average out or offset

errors, economic or operating, caused by underdepreciation or overdepreciation.iii. Periodic income is not distorted by gains or losses on disposal of assets.

11-62

CA 11-2 (Continued)

iv. A more useful charge to expense is derived from these methods because of their recog-nition that depreciation estimates are based on averages and that gains and losses onindividual assets are of little significance.

Arguments against the use of the group and composite-life methods would include:i. The methods would conceal faulty estimates for a long period of time.ii. When there is an early heavy retirement of assets a debit balance might appear in the

accumulated depreciation account and present an accounting problem.iii. Information is not available regarding a particular machine for cost-calculation purposes.iv. Under a decentralized financial control system where a measure of the division’s efficiency

is the rate of return on the gross book value of the investment, to improve the division’sfinancial reports a division manager might scrap idle but serviceable equipment orequipment that is not earning a satisfactory return on book value. The company wouldsustain an actual loss in the amount of the value of the equipment scrapped.

v. Under the same situation as “iv” above, except that net book value is used, where theassets, although serviceable, are fully or almost fully depreciated, the division managermight hesitate to replace them because of the high rate of return on investment.

(c) Under the unit method, retirements are recorded by removing from the accounts the cost of theasset and its related accumulated depreciation. The difference between the two accounts, adjustedfor salvage and disposal costs, if any, is recognized as gain or loss.

Under the group and composite-life methods the cost of the retired asset is removed from theasset account, and the accumulated depreciation account is reduced by the amount of the cost ofthe retired asset, adjusted for salvage, salvage costs, and removal costs. Accordingly, there is noperiodic recognition of gain or loss; the accumulated depreciation account serves as a suspenseaccount for the recognition of gain or loss until the final asset retirement.

CA 11-3

Situation I. This position relates to the omission of a provision for straight-line depreciation during astrike. The same question could be raised with respect to plant shut-downs for many reasons, such asfor a lack of sales or for seasonal business.

The method of depreciation used should be systematic and rational. The annual provision fordepreciation should represent a fair estimate of the loss in value arising from wear and usage and alsofrom obsolescence. Each company should analyze its own facts and establish the best method underthe circumstances. If the company was employing a straight-line depreciation method, for example, it isinappropriate to stop depreciating the plant asset during the strike.

If the company employs a units-of-production method, however, it would be appropriate not todepreciate the asset during this period. Even in this latter case, however, if the strike were prolonged, itmight be desirable to record some depreciation because of the obsolescence factors related to thepassage of time.

Situation II. (a) Steady demand for the new blenders suggests use of the straight-line method or theunits-of-production method, either of which will allocate cost evenly over the life of the machine.Decreasing demand indicates use of an accelerated method (declining-balance or sum-of-the-years’-digits) or the units-of-production method in order to allocate more of the cost to the earlier years of themachine’s life. Increasing demand indicates the use of the units-of-production method to charge moreof the cost to the later years of the machine’s life; an increasing-charge method (annuity or sinking-fund) could be employed, though these methods are seldom used except by utilities.

11-63

CA 11-3 (Continued)

(b) In determining the depreciation method to be used for the machine, the objective should be toallocate the cost of the machine over its useful life in a systematic and rational manner, so thatcosts will be matched with the benefits expected to be obtained. In addition to demand,consideration should be given to the items discussed below, their interrelationships, the relativeimportance of each, and the degree of certainty with which each can be predicted:

The expected pattern of costs of repairs and maintenance should be considered. Costs whichvary with use of the machine may suggest the use of the units-of-production method. Costswhich are expected to be equal from period to period suggest the use of the straight-linemethod. If costs are expected to increase with the age of the machine, an accelerated methodmay be considered reasonable because it will tend to equalize total expenses from period toperiod.

The operating efficiency of the machine may change with its age. A decrease in operatingefficiency may cause increases in such costs as labor and power; if so, an accelerated methodis indicated. If operating efficiency is not expected to decline, the straight-line method isindicated.

Another consideration is the expiration of the physical life of the machine. If the machine wearsout in relation to the passage of time, the straight-line method is indicated. Within this maximumlife, if the usage per period varies, the units-of-production method may be appropriate.

The machine may become obsolete because of technological innovation; it may someday bemore efficient to replace the machine even though it is far from worn out. If the probability ishigh that such obsolescence will occur in the near future, the shortened economic life shouldbe recognized. Within this shortened life, the depreciation method used would be determinedby evaluating such consideration as the anticipated periodic usage.

An example of the interrelationship of the items discussed above is the effect of the repairs andmaintenance policy on operating efficiency and physical life of the machine. For instance, ifonly minimal repairs and maintenance are undertaken, efficiency may decrease rapidly and lifemay be short.

It is possible that different considerations may indicate different depreciation methods for themachine. If so, a choice must be made based on the relative importance of the considerations.For instance, physical life may be less important than the strong chance of technologicalobsolescence which would result in a shorter economic life.

Situation III. Depreciation rates should be adjusted in order that the operating sawmills which are to bereplaced will be depreciated to their residual value by the time the new facility becomes available. Thestep-up in the depreciation rates should be considered as a change in estimate and prior years’financial statements should not be adjusted.

The idle mill should be written off immediately as it appears to have no future service potential.

11-64

CA 11-4

To: Merton Miller, Supervisor of Canning Room

From: Your name, Accountant

Date: January 22, 2007

Subject: Annual depreciation charge to the canning department

This memo addresses the questions you asked about the depreciation charge against your department.Admittedly this charge of $469,000 is very high; however, it is not intended to reflect the wear and tearwhich the machinery has undergone over the last year. Rather, it is a portion of the machines’ costwhich has been allocated to this period.

Depreciation is frequently thought to reflect an asset’s loss in value over time. For financial statementpurposes, however, depreciation allocates part of an asset’s cost in a systematic way to each periodduring its useful life. Although there will always be a decline in an asset’s value over time, thedepreciation charge is not supposed to measure that decline; instead, it is a periodic “charge” for usingpurchased equipment during any given period. When you consider the effect which the alternativewould have on your departmental costs—expensing the total cost for all six machines this year—I’msure you’ll agree that depreciation is more equitable.

You also mentioned that using straight-line depreciation would result in a smaller charge than wouldthe current double-declining balance method. This is true during the first years of the equipment’s life.Straight-line depreciation expenses even amounts of depreciation for each canning machine’s twelve-year life. Thus the straight-line charge for this and all subsequent years would be $35,750 per machinefor total annual depreciation of $214,500.

During the earlier years of an asset’s life, the double-declining balance method results in higher deprecia-tion charges because it doubles the charge which would have been made under the straight-linemethod. However, the same percentage depreciation in the first year is applied annually to the asset’sdeclining book value. Therefore, the double-declining balance charge becomes lower than the straight-line charge during the last several years of the asset’s life. For this year, as mentioned above, thecharge is $469,000, but in subsequent years this expense will become lower. By the end of the twelfthyear, the same amount of depreciation will have been taken regardless of the method used.

The straight-line method would result in fewer charges against your department this year. However,consider this: when the asset is new, additional costs for service and repairs are minimal. Thus agreater part of the asset’s cost should be allocated to this optimal portion of the asset’s life. After a fewyears, your department will have to absorb the additional burden of repair and maintenance costs.During that time, wouldn’t you rather have a lower depreciation charge?

I hope that this explanation helps clarify any questions which you may have had about depreciationcharges to your department.

CA 11-5

(a) The stakeholders are Waveland’s employees, including Baker, current and potential investorsand creditors, and upper-level management.

(b) The ethical issues are honesty and integrity in financial reporting, job security, and the externalusers’ right to know the financial picture.

11-65

CA 11-5 (Continued)

(c) Baker should review the estimated useful lives and salvage values of the depreciable assets.Since they are estimates, it is possible that some should be changed. Any changes should bebased on sound, objective information without concern for the effect on the financial statements(or anyone’s job).

(Note: This case can be used with Chapter 22, Accounting Changes and Error Analysis.)

11-66

FINANCIAL REPORTING PROBLEM

(a) P&G classifies its property, plant and equipment under three descrip-tions in its balance sheet: Buildings, Machinery and equipment, andLand.

(b) P&G’s “depreciation expense is recognized over the assets’ estimateduseful lives using the straight-line method.”

(c) P&G depreciates its assets based on estimated useful lives of 15 yearsfor machinery and equipment and 3 to 20 years for manufacturingequipment. Buildings are depreciated over an estimated useful life of40 years.

(d) P&G’s statement of Cash Flows reports depreciation and amortizationof $1,733 million in 2004, $1,703 million in 2003, and $1,693 millionwas charged to expense in 2002.

(e) The statement of cash flows reports the following capital expenditures:2004, $2,024 million; 2003, $1,482 million; and 2002, $1,679 million.

11-67

FINANCIAL STATEMENT ANALYSIS CASE

(a) McDonald’s used the straight-line method for depreciating itsproperty and equipment.

(b) Depreciation and amortization charges do not increase cash flowfrom operations. In a cash flow statement, these two items are oftenadded back to net income to arrive at cash flow from operations andtherefore some incorrectly conclude these expenses increase cashflow. What affects cash flow from operations are cash revenues andcash expenses. Noncash charges have no effect, except for positivetax savings generated by these charges.

(c) The schedule of cash flow measures indicates that cash provided byoperations is expected to cover capital expenditures over the next fewyears, even as expansion continues to accelerate. It is obvious thatMcDonald’s believes that cash flow measures are meaningful indicatorsof growth and financial strength, when evaluated in the context ofabsolute dollars or percentages.

11-68

COMPARATIVE ANALYSIS CASE

(a) Property, plant, and equipment, net of accumulated depreciation:

Coca-Cola at 12/31/04 $6,091 millionPepsiCo at 12/25/04 $8,149 million

Percent of total assets:

Coca-Cola ($6,091 ÷ $31,327) 19.4%PepsiCo ($8,149 ÷ $27,987) 29.1%

(b) Coca-Cola and PepsiCo depreciate property, plant, and equipmentprincipally by the straight-line method over the estimated useful livesof the assets. Depreciation expense was reported by Coca-Cola (includesamortization) and PepsiCo as follows:

Coca-Cola PepsiCo

2004 $893 million $1,062 million2003 850 million 1,020 million2002 806 million 929 million

(c) (1) Asset turnover:

Coca-Cola PepsiCo

$21,962 $29,261$31,327 + $27,342

= .75$27,987 + $25,327

= 1.10

2 2

11-69

COMPARATIVE ANALYSIS CASE (Continued)

(2) Profit margin:

Coca-Cola PepsiCo

$4,847 $4,212$21,962

= 22.07%$29,261

= 14.39%

(3) Rate of return on assets:

Coca-Cola PepsiCo

$4,847 $4,212$31,327 + $27,342

= 16.52%$27,987 + $25,327

= 15.8%

2 2

With the exception of the asset turnover ratio, each of Coca-Cola’sratios is superior to PepsiCo’s, especially the profit margin. PepsiCo’slower margins are primarily due to its large food business whichexperiences larger investments in property, plant, and equipment andlower margins compared to the beverage segment. Coca-Cola salesare derived almost entirely from higher margin beverages.

(d) Coca-Cola’s capital expenditures were $755 million in 2004 whilePepsiCo’s capital expenditures were $1,387 million in 2004.

Neither Coca-Cola nor PepsiCo reported capitalizing any interest aspart of construction costs.

11-70

RESEARCH CASE

(a) EBITDA is an income subtotal that adds back certain expenses.Specifically, EBITDA stands for “Earnings before interest, taxes,depreciation, and amortization.” Companies report EBITDA because itmore closely approximates cash flow from operations. Some companiesfeel that their financial results are unfairly tainted by accounting rulescalling for depreciation when in fact the infrastructure that they weredepreciating was holding its value. Other companies, who had beendoing acquisitions liked to focus on EBITDA because they could addback goodwill amortization, which before FAS No. 142 was amortizedto expense.

(b) The Worldcom case highlighted the importance of depreciation expenseas an operating expense. Worldcom wrongly treated $3.8 billion incertain operating expenses as capital expenditures. As a result the costswere not immediately expensed, but were subject to depreciation.While the move enhanced current earnings, it has an even moredramatic effect on EBITDA, which also excludes depreciation from theearnings measure. As a result, holders of other EBITDA-oriented stocksditched them based on the worry that the same EBITDA-enhancinggames were going on at these companies.

(c) The biggest problem appears to be the bias in choosing which non-earnings measure to report. Investors have a growing disdain foralternative measures that exclude a wide range of costs whileincluding all manner of gains. Many believe that net income providesa more reliable picture of a company’s financial performance. Inparticular, EBITDA is a poor metric for companies with highdepreciation and amortization because it results in misleading com-parisons to companies with lower depreciation and amortization.Some have criticized EBITDA and other pro-forma metrics becausethey give companies too much flexibility in deciding how to accountfor expenses.

11-71

INTERNATIONAL REPORTING CASE

Liberty Kimco

(a) (1) ROA £125 $297£5,577

= 2.2%$4,696

= 6.32%

Liberty Kimco

(2) Profit £125 $297 Margin £741

= 16.9%$517

= 57.5%

Liberty Kimco

(3) Asset £741 $517 Turnover £5,577

= .13$4,696

= .11

Based on return on assets (ROA), Kimco is performing better thanLiberty. The main driver for this difference is strong profit margin,which is over three times that of Liberty. Even though Liberty has ahigher asset turnover (.13 vs. .11), this results in only a 2.2% ROAwhen multiplied by the lower profit margin.

Summary Entry(b) Land and Buildings......................................................... 1,550

Revaluation Reserve............................................ 1,550

(c) Relative to U.S. GAAP, an argument can be made that assets andequity are overstated. Note that in the entry in (b) above, the reva-luation adjustment increases Liberty’s asset values and equity. Tomake Liberty’s reported numbers comparable to a U.S. company likeKimco, you would need to adjust Liberty’s assets and equity numbersdownward by the amount of the revaluation reserve.

11-72

INTERNATIONAL REPORTING CASE (Continued)

For example, after adjusting Liberty’s assets downward by the amountof the revaluation reserve, Liberty’s ROA increases to:

$125($5,577 – $1,952)

= 3.45%.

This is still lower than Kimco’s ROA but the gap is narrower afteradjusting for differences in revaluation.

Note to instructors: An alternative way to make Liberty and Kimco compa-rable is to adjust Kimco’s assets to fair values. This approach could beused to discuss the trade-off between relevance and reliability.

11-73

PROFESSIONAL RESEARCH: ACCOUNTING AND FINANCIAL REPORTING

Search Strings: “impairment of assets,” “impairment and testing,” “evidence of fair value,” “impairmentloss”

(a) INTRODUCTIONFAS144, Par. 1

1. This Statement addresses financial accounting and reporting for the impairment of long-livedassets and for long-lived assets to be disposed of. This Statement supersedes FASB State-ment No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto Be Disposed Of. However, this Statement retains the fundamental provisions of Statement121 for (a) recognition and measurement of the impairment of long-lived assets to be heldand used and (b) measurement of long-lived assets to be disposed of by sale.

It would appear that this standard covers a potential impairment of these long-lived assets.

(b) FAS144, Par. 8

When to Test a Long-Lived Asset for Recoverability

A long-lived asset (asset group) shall be tested for recoverability whenever events or changes incircumstances indicate that its carrying amount may not be recoverable. The following are examplesof such events or changes in circumstances:

a. A significant decrease in the market price of a long-lived asset (asset group)b. A significant adverse change in the extent or manner in which a long-lived asset (asset group)

is being used or in its physical conditionc. A significant adverse change in legal factors or in the business climate that could affect the value

of a long-lived asset (asset group), including an adverse action or assessment by a regulatord. An accumulation of costs significantly in excess of the amount originally expected for the

acquisition or construction of a long-lived asset (asset group)e. A current-period operating or cash flow loss combined with a history of operating or cash flow

losses or a projection or forecast that demonstrates continuing losses associated with the useof a long-lived asset (asset group)

f. A current expectation that, more likely than not, a long-lived asset (asset group) will be sold orotherwise disposed of significantly before the end of its previously estimated useful life.

(c) Fair Value—FAS144, Par. 22–24

22. The fair value of an asset (liability) is the amount at which that asset (liability) could be bought(incurred) or sold (settled) in a current transaction between willing parties, that is, other than ina forced or liquidation sale. Quoted market prices in active markets are the best evidenceof fair value and shall be used as the basis for the measurement, if available. However,in many instances, quoted market prices in active markets will not be available for the long-lived assets (asset groups) covered by this Statement. In those instances, the estimate of fairvalue shall be based on the best information available, including prices for similar assets(groups) and the results of using other valuation techniques.

11-74

ACCOUNTING AND FINANCIAL REPORTING (Continued)

23. A present value technique is often the best available valuation technique with which toestimate the fair value of a long-lived asset (asset group). Paragraphs 39–54 of FASBConcepts Statement No. 7, Using Cash Flow Information and Present Value in AccountingMeasurements, discuss the use of two present value techniques to measure the fair value ofan asset (liability). The first is expected present value, in which multiple cash flow scenariosthat reflect the range of possible outcomes and a risk-free rate are used to estimate fair value.The second is traditional present value, in which a single set of estimated cash flows and asingle interest rate (a rate commensurate with the risk) are used to estimate fair value. Eitherpresent value technique can be used for a fair value measurement. However, for long-livedassets (asset group) that have uncertainties both in timing and amount, an expected presentvalue technique will often be the appropriate technique. (Example 4 of Appendix A illustratesthe use of that technique.)

24. If a present value technique is used, estimates of future cash flows shall be consistent with theobjective of measuring fair value. Assumptions that marketplace participants would use intheir estimates of fair value shall be incorporated whenever that information is availablewithout undue cost and effort. Otherwise, the entity may use its own assumptions.

11-75

PROFESSIONAL SIMULATION

Explanation

(a) The purpose of depreciation is to allocate the cost (or other bookvalue) of tangible capital assets, less salvage, over their useful lives ina systematic and rational manner. Under generally accepted accoun-ting principles as presently understood, depreciation accounting is aprocess of allocation, not of valuation, through which the productiveeffort (cost) is to be matched with productive accomplishment (revenue)for the period. Depreciation accounting, therefore, is concerned withthe timing of the expiration of the cost of tangible plant assets.

(b) The factors relevant in determining the annual depreciation for adepreciable asset are the initial recorded amount (cost), estimatedsalvage value, estimated useful life, and depreciation method.

Assets are typically recorded at their acquisition cost, which is in mostcases objectively determinable. Cost assignments in other cases—“basket purchases” and the selection of an implicit interest rate in assetacquisition under deferred-payment plans—may be quite subjective,involving considerable judgment.

The salvage value is an estimate of an amount potentially realizablewhen the asset is retired from service. The estimate is based onjudgment and is affected by the length of the useful life of the asset.

The useful life is also based on judgment. It involves selecting the“unit” of measure of service life and estimating the number of suchunits embodied in the asset. Such units may be measured in terms oftime periods or in terms of activity (for example, years or machinehours). When selecting the life, one should select the lower (shorter)of the physical life or the economic life. Physical life involves wear andtear and casualties; economic life involves such things as technologicalobsolescence and inadequacy.

11-76

PROFESSIONAL SIMULATION (Continued)

Measurement

(a) Compared to the use of an accelerated method, straight-line deprecia-tion would result in the lowest depreciation expense and the highestincome. For example, under straight-line depreciation, expense ineach year would be:

($100,000 – $10,000)/4 = $22,500

Using the double-declining balance method, depreciation expense in2006 would be:

$100,000 X (1/4 X 2) = $50,000

Depending on the level of use in the first year, use of the units-of-production method could yield an even lower expense in the first yearcompared to straight-line.

(b) Over the entire four-year period, all methods will produce the sametotal depreciation expense. Use of alternative methods only results indifferences in timing of the depreciation charges.

(c) All methods used for financial reporting purposes results in the samecash flow in 2006. That is, a cash outflow of $100,000 for acquisitionof the machine. However, use of an accelerated method for taxpurposes, such as MACRS, results in the higher cash flow in 2006.This is because a larger tax deduction can be taken for depreciationexpense, which reduces taxable income, resulting in less cash paidfor taxes. Note that over the life of the asset, cash flows for taxes arethe same regardless of the tax depreciation method used. Use ofMACRS simply allows companies to defer tax payments.

Journal Entry

Cash........................................................................... 84,000Accumulated Depreciation................................. 45,000*

Gain on Sale of Equipment...................... 29,000Equipment..................................................... 100,000

*($100,000 – $10,000)/4 = $22,500 per year X 2 years (2006, 2007)

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